Real Yields Rise, REITs and Other Riskier Assets Recover in First Half of 2009

The Dow-Jones U.S. Select Real Estate Investment Trust (REIT) Total Return Index posted a gain of 31.46 percent during the quarter with most sectors contributing significantly. Perceptions of U.S. economic recovery sent shares higher along with the broader equity market. Another major driver of the rally was the sector’s ability to raise $22 billion of equity so far in 2009 while also issuing new debt, which greatly reduced the risk of bankruptcy. The Hotels and Retail-Malls sectors posted the strongest gains, 74.64 percent and 59.06 percent, respectively, while the Manufactured homes sector was the weakest, posting a modest 2.69 percent return.

Interest rates rose and capital flowed back toward riskier assets during the first half of 2009. Government policy initiatives helped restore a measure of stability to financial markets after the extreme stress and volatility of last year. Treasury Inflation Protected Securities (TIPS) gained 0.66 percent during the second quarter as represented by the Barclays Capital U.S. TIPS Index. Real yields generally rose, but TIPS were kept in positive territory by strong inflation accruals and to a lesser extent real coupon payments. TIPS far outperformed their nominal Treasury counterparts, as nominals ended in deep negative territory.

Real yields generally rose with the exception of shorter maturities where yields declined as demand for these shorter maturity TIPS increased due to rising energy prices, which tend to positively impact these issues more so than intermediate or long-dated TIPS. Long-dated real yields rose considerably less than intermediate yields as longer maturity TIPS were somewhat supported by liability-matching demand given the elevated potential for inflation risks. Two-year real yields ended the period at 0.57 percent, 33 basis points lower than at the beginning of the quarter; ten-year real yields closed at 1.75 percent, 35 basis points higher, while 20-year real yields closed 11 basis points higher at 2.10 percent.

Real yields rose, however, nominal yields rose considerably more leading to the strong outperformance of TIPS over nominal Treasuries. The difference in these yields of comparable maturity, or the breakeven inflation rate (also the level of inflation it takes for a TIPS issue to breakeven with a nominal Treasury) increased as a result. Part of this outperformance was due to markets pricing in higher inflation expectations, in addition to market concerns that massive fiscal expenditures could lead to a glut of nominal Treasuries.

While measures of inflation expectations increased in the first six months of 2009, actual inflation, especially when adjusted for food and energy prices, was subdued. With unemployment approaching 10 percent in the U.S. there was plenty of slack in the economy to restrain price increases. Perhaps the most encouraging economic news came on the final day of the second quarter, with data showing a slower rate of decline in residential property prices. That raised hopes that the real estate slump might be nearing a bottom.

Non-Treasury Sectors Recover to Pre-Crisis Levels

Risk appetites returned to financial markets in the first six months of 2009. In general, valuations of corporate bonds, mortgages and other asset–backed securities recovered to levels last seen before the financial crisis of last fall, though risk premiums for many assets remained elevated compared to historical norms. The following is a summary of fixed income sector performance:

• Agency mortgage-backed securities (MBS) outperformed Treasuries on a like-duration basis for the second quarter and the year-to-date. Purchases of Agency mortgages by the Fed was a powerful boost to the market and helped drive mortgage yields down relative to Treasuries since the start of the year. Non-agency mortgages also rallied. Yield premiums on many consumer asset-backed securities (ABS), such as credit cards, student loans and auto ABS fell by more than half from the beginning of the year. These markets benefitted from an infusion of liquidity from the government’s Term Asset-backed Securities Loan Facility, or TALF, which provided financing to investors buying consumer asset-backed securities.
• Corporate bonds also rallied strongly in the second quarter and the year-to-date, far outpacing Treasuries. Performance was best in the lower quality tiers, where credit premiums on some bonds plunged by more than 1,000 basis points (10 percent) from the start of the year. Lower risk premiums for high yield credits prompted a flood of new issuance in the second quarter. High grade credit premiums narrowed by 200-300 basis points. Investment grade bonds of banks and financial institutions outperformed the broader market in the second quarter as some banks began to wean themselves off government aid. Several major banks were able to sell bonds without government guarantees.
• Municipal bonds outperformed Treasuries during the quarter and the year-to-date. Yield premiums between municipals and comparable maturity Treasuries tightened back toward historical norms amid strong fund flows into the sector, though the longer end of the municipal yield curve remained attractively priced. New issuance of municipal bonds revived during the second quarter, especially Build America Bonds, a new type of taxable debt that benefits from an interest subsidy by the U.S. government.
• Credit premiums on emerging market (EM) bonds also narrowed sharply, helping produce gains in both local and external EM markets. The patterns were similar to U.S. credit markets, with lower tier credits benefitting the most.
• Government bonds of most developed economies fared better than more volatile U.S. Treasuries during the second quarter and year-to-date. Investor anxiety about fiscal imbalances and potential inflation was especially acute in the U.S.

PIMCO uses real estate-linked derivatives to gain exposure to the investment returns of the real estate markets, without investing directly in real estate properties. PIMCO fully collateralizes these positions with fixed income securities, mainly Treasury Inflation- Protected Securities (TIPS) that are actively managed with the objective of outperforming the cost of gaining real estate exposure (to deliver excess return) and to provide an additional inflation hedge beyond real estate. As excess returns are primarily derived from our fixed income management, comments below are focused on the bond market, especially TIPS, and our fixed income strategies

The RealEstateRealReturn Strategy Fund outperformed its benchmark, the Dow-Jones U.S. Select Real Estate Investment Trust (REIT) Total Return Index, during the second quarter and year to date. A focus on attractively priced high quality assets was beneficial as valuations improved; this approach helped mitigate risks of continued weak economic fundamentals.

The following strategies helped second quarter returns:

• The TIPS collateral outperformed the LIBOR return within the derivatives linked to the index due to strong inflation accruals
• Underweight TIPS duration, as real interest rates sold-off slightly from their strong first quarter rally
• TIPS yield curve positioning, with an underweight focused in the 10-year sector of the curve, which underperformed the most
• Nominal yield curve steepening strategies, which focused on exposure to short maturities in the U.S., U.K. and Europe, as yield curves generally steepened and shorter maturities outperformed
• Positions in Japanese government inflation-linked bonds (ILBs); real yields rallied stemming from the Japanese government’s repurchase program
• Holdings of high quality Agency mortgage pass-through securities, as these bonds rallied from continued government support
• Modest exposure to corporate bonds of financial companies, which rallied as major banks began to wean themselves off government aid

The following strategies were negative for quarterly returns:

• Above index total duration stemming from tactical exposure to nominal bonds; nominal interest rates rose
• An emphasis on nominal debt over ILBs in the U.K. and Eurozone; ILBs outperformed their nominal counterparts in the region

PIMCO’s Secular Outlook: A “New Normal”

PIMCO believes that secular economic, social and political trends exert the most powerful and sustained influences on bond markets. We define “secular” as the next three to five years. The key assumption of our Secular Outlook is that following the severe shocks to the global economy in the second half of 2008, the world embarked upon a journey of change not likely to be reversed over the next few years. This journey, which is expected to be characterized by starts, stops and volatility, will end at a destination that can be described as a “New Normal”. Some of its features are outlined below:

• Slow Growth in Developed Economies – Growth rates in developed economies are likely to be lower over the next three to five years. Potential growth in the U.S. could fall from 3 percent in the recent past to around 2 percent. Debt exhaustion at the household level and deleveraging among financial institutions will make it difficult for the global economy to adjust as it has in prior economic crises.
• Politics Matter – Another reason for muted growth will be a dampening of productivity as the public sector overstays as a provider of goods that belong in the private sector. More regulation and higher taxes will restrain the growth of output. While government involvement was clearly necessary to stabilize the financial system, the global economy is now highly vulnerable to policy mistakes. These could include protectionism, mismanagement of public finances and the overriding of investors’ contract rights.
• Emerging Economies to Bifurcate – Emerging economies should grow faster than the developed world. There will be a continued shift in the balance of economic power away from developed economies toward important emerging countries. The latter will divide into two groups. Countries with fiscal and economic imbalances will return to the old paradigm that alternates between austerity and instability. Those in stronger financial condition such as China will maintain their development breakout phase, though not at the torrid pace of recent years.
• Short Term Deflation, Long Term Inflation – Deflation risks should predominate in the near term given the severity of the collapse in global demand and the large gap in actual versus potential output. Inflation risks will arise later in PIMCO’s secular horizon. Potential output could be more constrained due to supply destruction while policymakers struggle to withdraw massive levels of monetary and fiscal stimulus that have recently been introduced.
• U.S. Dollar Risk – In the U.S., inflation risk and currency risk are linked. Should U.S. policymakers lack the commitment or the skill to drain the system of emergency liquidity at the appropriate time, confidence in the U.S. dollar as the world’s reserve currency could erode.
• Banking and Finance to Shrink – The financial sector’s formerly commanding presence in the economy will be curtailed. With regulation more expansive, the sector will be de-risked, de-levered and possibly subject to greater burden sharing imposed by politicians. Consolidation will spread beyond banks to non-bank financial institutions and the investment management industry.

PIMCO does not take a short-term view on real estate values. REIT prices tend to rise along with prospects for rising rental rates and property values. Most REIT debt is fixed rate rather than floating. Therefore, we do not expect REIT cash flow and income distribution to be significantly impacted by changes in interest rates. Lower (higher) interest rates in the marketplace will likely make an existing REIT yield more (less) attractive. PIMCO’s outlook for TIPS is that they continue to be attractively priced historically both on an absolute basis and relative to nominal Treasuries. The outlook includes low growth rates in developed economies while longer-term inflationary pressures build, owing to stimulative government policy, growth in developing economies, secular commodity infrastructure constraints, and a longer term weaker dollar caused by the twin U.S. deficits

PIMCO’s Cyclical Outlook: A W-Shaped Recovery

Monetary and fiscal stimulus, along with a rebuilding of inventories will be tailwinds for the U.S. economy for the rest of 2009. These positive effects will begin to fade in 2010 at the same time as consumer spending is constrained by high debt levels. A W-shaped recovery will set in, consistent with the muted growth rates PIMCO expects for developed economies over a secular time frame. Federal Reserve tightening is unlikely before the summer of 2010 given this forecast.

Investment Implications of PIMCO’s Economic Outlook

PIMCO uses real estate-linked derivatives to gain exposure to the investment returns of the real estate markets, without investing directly in real estate properties. PIMCO fully collateralizes these positions with fixed income securities, mainly Treasury Inflation- Protected Securities (TIPS) that are actively managed with the objective of outperforming the cost of gaining real estate exposure (to deliver excess return) and to provide an additional inflation hedge beyond real estate. As excess returns are primarily derived from our fixed income management, comments below are focused on the bond market, especially TIPS, and our fixed income strategies.

Our Secular Outlook guides how we structure portfolios in terms of duration, yield curve positioning, sector exposure, credit quality and other risk measures. It also informs our thinking for business management, client service and product development. Broad investment implications of the Secular Outlook are:

• Favor the Front End of Nominal Yield Curves – Yields on short maturities are likely to be anchored near current low levels for a longer period than what is now priced into forward interest rate curves. Policymakers in many countries are likely to overstay with loose monetary policy.
• Emphasize Income-Producing Securities – Low growth and political uncertainty favor high quality, yield-oriented securities over those offering mainly capital gains. With regard to credit risk, it will make sense to stay relatively high up in capital structures, as yield premiums and valuations of equities and subordinated securities will reflect heightened risks of burden sharing and contract disruptions.
• Focus on Global and Select Emerging Market Securities Diversification outside the U.S. will likely yield benefits. U.S. bonds will face greater sovereign risk as the U.S. debt burden mounts and inflation expectations start to rise later in our secular time frame.
• Hedge Against a Weaker U.S. Dollar – Investors should protect themselves against the risk that U.S. policymakers will not prevent erosion in the value of the dollar. The magnitude of the dollar’s depreciation against other currencies could be outpaced by its fall against real assets.

With the Secular Outlook as a foundation, PIMCO refines risk exposures and strategies based on its cyclical economic outlook spanning the next 12-18 months. These strategies include:

• Real and Nominal Interest Rate Strategies – With nominal Treasury yields near the top of our expected range, PIMCO will overweight nominal duration via high quality, higher yielding nominal bonds. As a result, TIPS duration will be maintained near the index. However, consistent with our Secular Outlook, we will also retain an emphasis on the short end of nominal curves in the U.S. as the Fed is likely to tighten more slowly than markets expect. Duration exposure will also likely be expressed through inflation-linked bonds (ILBs) in Japan, where relatively high real yields do not reflect current slow economic growth. Nominal duration will likely be favored over real duration in the U.K. and Eurozone, as long-dated U.K. ILBs remain rich from liability-matching demand and inflation in the Eurozone is likely to move lower.
• Mortgages – PIMCO will retain exposure to Agency mortgages, though at reduced levels. The strong rally in these securities has driven yield premiums closer to fair value, but they still remain a relatively attractive source of high quality income. PIMCO will trim more modest holdings of upper tier non-Agency mortgages, which have also rallied.
• Credit – High grade corporate valuations remain attractive. PIMCO will retain positions in sectors with defensive characteristics and assets that provide strong collateral, such as pipeline, utility, telecom and energy companies. Our holdings of financials will be trimmed after their recent rally. We will continue to avoid high yield bonds. With their credit premiums having narrowed from recent wides, high yield bonds are vulnerable to an expected rise in defaults and risks of government-imposed burden sharing.
• Municipals – PIMCO will retain municipal bond positions focused on longer maturities, which offer the most attractive relative value after recent gains in the municipal sector. We will seek to harvest gains in other municipal holdings where yield premiums relative to Treasuries are now less attractive.